C
1 C I 1
2 D I 2
3 I A C A 4
3.1 Question 1: Business Attractive Or Predictable? Executive Summary: Attrac- tive, Not Predictable ...... 4 3.1.1 Customers ...... 4 3.1.2 Suppliers ...... 6 3.1.3 Substitutes ...... 6 3.1.4 New Entrants ...... 6 3.1.5 Competition ...... 6
3.2 Question 2: Competitive Advantage? Executive Summary: Yes ...... 7
4 V A P 11
4.1 Question 3: Intrinsic Value And Margin Of Safety Executive Summary: Under- valued ...... 11 4.2 Question 4: Who is selling and why is it cheap? ...... 12
5 D A V A 14
5.1 Question 5: Financial Value Add Executive Summary: Applicable ...... 14 5.2 Question 6: Operational Value Add Executive Summary: Applicable ...... 14 5.2.1 Short-Term ...... 14 5.2.2 Long-Term ...... 15
5.3 Question 7: Acquisition Advantage Executive Summary: Yes ...... 16
6 R A R 17 6.1 Question 8: Worst Case Scenario ...... 17
i Contents
6.2 Question 9: Investor Mistakes And Punch Card Test Executive Summary: Pass . 19
7 C 22
8 A C A : A E C 23
9 A 26
ii 1 C I
The U.S. based PayPal Holdings, Inc. (hereafter “PayPal” or “the company”) is an worldwide operating online payment provider mainly for the eCommerce industry, which enables software based digital and mobile payments for commercial users as well as merchants.1 PayPal has digitized the payment method by connecting buyers and sellers via a two-sided platform. While doing so, the company charges fees for providing transaction processing and other payment-related services as source of revenues.2 Established in 1998, PayPal was acquired by eBay shortly after the IPO in late 2002. Driven by the strong demand of star investor Carl Icahn, eBay separated its payment transaction business into an independent, listed company (PayPal Holdings) in 2015.3 So far, PayPal has over 250 million users and supports 25 currencies from over 200 markets,4 which makes them one of the most widely accepted digital and mobile payment provider.
1. Cf. PayPal (2018), annual report 2017, page 1. 2. Cf. ibidem. 3. Cf. https://www.reuters.com/article/us-investments-funds-icahn/icahn-exits-ebay-stake- opts-for-paypal-after-spinoff-idUSKCN0T52SP20151117 (02.12.18). 4. Cf. https://www.paypal.com/c2/webapps/mpp/merchant?locale.x=en_C2 (02.12.18).
1 2 D I
”Visa and PayPal have a shared goal of giving consumers a safe, convenient way to pay using their preferred device. Expanding our partnership [...] provides greater consumer choice and benefits merchants.”5 - Bill Sheedy, CEO Europe, Visa Inc.
This paper recommends a merger between PayPal, a key player in digital and mobile based payment solutions, and Visa Inc. (hereafter ”Visa”), the market leader in the credit card business. The proposed merger yields manifold advantages for both parties and helps them to compete with other key players like Apple and Alibaba in the future. The two companies have already successfully worked together in the past on solutions for online and in-app payments as well as payments in stores.6 In the future, this collaboration could be expanded to allow PayPal, with its banking license in Europe, to act as a Visa emitter itself, allowing consumer and business to use PayPal wherever Visa is accepted worldwide.7 With the deal PayPal enters the retail market, while Visa at the same time profits from the digital, mobile and eCommerce focused network of PayPal. As stated by Mr. Sheedy, the consolidated network will gain customer’s utility on both sides. As being former rivals, we think that the combined network will provide a short-term and a long-term benefit, resulting in increased revenues. In the short-term, for all customers and merchants the availability will increase instantly by adding the respective other network. Secondly, the enlarged network will attract more customers and therefore provide sustainable long-term growth. Additionally, the value of the data in this network and services provided is very difficult to replicate on the scale and the precision that the Visa-PayPal-network would develop. Every company states, that they have a competitive advantage, while having non, but this natural network entrance barrier indeed yields a competitive advantage for the arising Visa-PayPal conglomerate. The proposed merger should be fulfilled as a merger by acquisition to incorporate PayPal into Visa. We recommend it this way around because Visa has almost four times higher free liquidity and an overall strong and bigger balance sheet compared to the leaner balance sheet of PayPal.8
5. https://investor.visa.com/news/news-details/2017/Visa-and-PayPal-Extend-Partnership- to-Europe-7182017/default.aspx (04.12.18). 6. Cf. PayPal (2018), annual report 2017, page 11. 7. Cf. https://investor.visa.com/news/news-details/2017/Visa-and-PayPal-Extend-Partnershi p-to-Europe-7182017/default.aspx (04.12.18). 8. Cf. respective annual reports 2017.
2 2 Deal Introduction
While assuming a premium of 20% the total acquisition price of the company would be USD 126.7 billion, using the current stock price of USD 87.98,9 making it the fourth largest deal in global history.10 If Visa were to finance the purchase merely with debt, their debt to capital ratio would increase from 23% up to 73%. As a common used alternative they could offer shareholders of PayPal shares of Visa instead of cash compensation. Since the exchange ratio is assumed to be not an even number,11 Visa would only have to pay a one-off compensation payment. To avoid a debt overhang we recommend to combine both described acquisition methods. Leaving them with a debt to capital ratio of 40%.12 This would leave Visa at issuing USD 61.7 billion debt.
Graph 1: Proposed merger by acquisition structure. Own graphic.
9. Noting that the stock price is currently in the upper quartile of the 52-week-range, buying at a later time could lower the acquisition price given the volatility of PayPal’s stock price in the last 6 month. 10. Cf. https://finance.yahoo.com/news/15-biggest-mergers-time-175152979.html (06.12.18). 11. We realistically assume that the objectifiable company values are not in multiple proportion. 12. To get this value, we used the Excel target value search.
3 3 I A C A
3.1 Q 1: B A O P ? E S :
A , N P
In order to assess whether the industry is attractive and/or predictable, we use a slightly modified Porter 5-Forces model in the following.
3.1.1 C
WHO ARE THE CUSTOMERS: Every commercial user and merchant involved in online payment transactions is customer of the digital payment industry. This includes customers of purely elec- tronic software based solutions, like PayPal offers, as well as more traditional non-software based solutions like online banking and credit card payment methods.
HOW MANY CUSTOMERS EXIST: Since the business of digital transactions not only includes the B2C market (merchant to consumer) but also enables B2B and person to person (P2P) transactions, it is difficult to precisely define the industry and its total customer base. However, the industry’s main total payment volume and original purpose is the connection between the seller and buyer, which is why we focus on the eCommerce market in the following.13 The eCommerce market has a customer base of 2,818 million users in 2018 and grew by 3.1%.14 The number of users is expected to increase to 3,263 million by 2023.15
WHAT DO CUSTOMERS CARE ABOUT: The consumer side of the customers mostly cares about security because their savings are involved. The security aspect applies not only to buyer protection with full reimbursement for eligible purchases, but also to secure retention and no redistribution of all financial details. However, this is not sufficient on its own. The payment option must be available to customers in as many markets as possible worldwide and function as quickly and
13. In addition, this is where company’s like PayPal generate their primary revenues by charging fees; cf. PayPal (2018), annual report 2017, page 1. 14. https://www.statista.com/outlook/243/100/ecommerce/worldwide#market-revenue (02.12.18). 15. Cf. ibidem.
4 3 Industry And Company Analysis convenient as possible. Although we suspect that customers would be willing to pay a premium for using PayPal in return for security, they certainly want to have low or no costs caused by the payment option.16 On the other side of the transaction, merchants care most about the charge associated with the payment, reliability and also diversifying and keeping up with offering the consumer’s most wanted payment options. Delayed money transaction increase administrative costs they want to receive the payment as fast as possible. Usually the delivery is initiated after the payment is received. Thus, with a fast digital payment the process is accelerated for both parties.
BUYING PROCESS AND FREQUENCY: We use the MHAECC not R checklist in order to analyze the buying process for consumers (B2C).17 As we are PayPal consumer ourselves, we think, due to fact that the safety of our money and data in the cyberspace are at stake, the process of choosing the payment option is not mindless, aspirational, emotional nor chemical. It is a critical choice, therefore we expect consumers to act rational as we did. However, once the consumer chose a payment option, we assess him or her to stick with it in future transaction as a habit and because of high perceived switching cost. For the merchant on the other hand the decision for one or multiple payment options is even more rational since most of the fees apply on the merchant’s side of the transaction. In the B2B world decision making is usually almost exclusively rational. We assess the transaction frequency as high. In 2016, 70% of worldwide online shop users did at least one transaction per month, 16% of them even once a week.18 As this is already high, we conclude that the usage frequency of the merchant is even higher. Big online shops receive several thousands orders a day.
16. Cf. for the pevious paragraph https://www.paypal.com/c2/webapps/mpp/consumer (03.12.2018). 17. Cf. Jeffrey Towson (2018), Private Equity Investment Committee class 2018, checklist attractive industry B2C. 18. Cf. https://www.statista.com/statistics/664770/online-shopping-frequency-worldwide/ (03.12.18).
5 3 Industry And Company Analysis
3.1.2 S
Due to the characteristics of the industry the required inputs are almost limited to electricity and server capacity. For both these commodity products the industry doesn’t provide any advantage nor disadvantage. Like in other industries the bargained price mainly relies on the specific company size.
3.1.3 S
Industry substitutes would only be non-digital transactions such as invoice payments, direct debits, cash on delivery, or simply cash purchases. These alternatives take longer, are less convenient and generally outdated, which is why those substitutes don’t threat digital transactions.
3.1.4 N E
Basically, it is possible to develop the software to enter the market. However, the big entrance barrier to the industry is the existence of an already fully developed competitive network. The payment option is only beneficial for customers if it is offered for many online shops respective used by many consumers. At this point of time a new entrant has to offer unexpected advantages for their customers to built a sufficiently large network to compete with the existing big players. Although, this limits the possibility of new entries, for a big company that already has an underlying network and capacity to suffer, the entrance in the online payment industry is possible and could be critical for existing players.19 Another entrance barrier are regulatory licenses, which enable to operate in markets.
3.1.5 C
The online payment industry is highly competitive.20 Firstly, there are many key players that ben- efit from an existing customer base. These are primarily big companies like Apple (Apple Pay),
19. For instance, Amazon did this a few years ago with its service Amazon Pay and is recently building up a payment network based on their already existing and big customer base; cf. https://www.amazon.com/gp/help/custo mer/display.html?ie=UTF8&nodeId=201895570 (03.12.18). 20. Cf. PayPal (2018), annual report 2017, page 4.
6 3 Industry And Company Analysis
Amazon (Amazon Pay), Tencent (WeChat Pay), Alibaba (Alipay). Additionally, the banking sector provides competition with credit card providers or online banking methods (digitalization of tradi- tional banking). Finally, there are companies that only focus on the provision of online payment services like PayPal itself. Secondly, the industry is competitive on many different operative levels. This concerns for in- stance the simplicity of the payment method and fee structure, system reliability and data security or customer service.21
In conclusion of the interim analysis, the industry is attractive for existing players that already developed large networks, but not for newcomers. The main reason for this is the expected growth in the future, not only in users but also in transaction volume and frequency. Except for the growth prediction it is difficult to predict further developments in the industry due to the nature of fast changing technology and customer behavior. Furthermore, it is hardly assessable which key players will succeed in terms of market share, or which new big players will arise.
3.2 Q 2: C A ? E S : Y
Every company believes it has a competitive advantage. In order to test whether there is one for PayPal, we base our analysis on the ideas of the legendary investor Warren Buffett and thus firstly focus on the ROIC (in relation to the WACC) and the market share.22
ROIC: PayPal’s four year average ROIC23 is 5.4%, which is under the peer group24 average and even lower than the WACC of PayPal, which is 8.02%25. This usually indicates, that the company is not wealth creation. However, in this industry the ROIC might not be an accurate measure for
21. Cf. PayPal (2018), annual report 2017, page 4f. 22. Cf. Jeffrey Towson (2018), Legends in Investing class 2018, lecture 2, slide 101. 23. We define ROIC as NOPAT divided by invested capital, where invested capital = total assets – NOA. Due to aggregated balance sheet items, we use total assets minus cash and cash equivalents as an approximation of the NOA. 24. We chose the peer group based on the financial companies that PayPal identified as their direct competitors in terms of financial performance; cf. PayPal (2018), Proxy Statement 2018, page 47. 25. See WACC calculation in the appendix.
7 3 Industry And Company Analysis wealth creating because the terms of payment of 30 days leads to a significant balance sheet exten- sion and subsequently lower the calculated ROIC.
MARKET SHARE: We measure the market share by total payment volume in relation to the total revenue volume of the eCommerce market.26 In 2017, PayPal has a transaction volume of USD 451 billion, resulting in a eCommerce market share of 25.26%. In the last years, PayPal’s market share increased almost linearly from roughly 16% in 2015. This speaks for PayPal having a competitive advantage.
DEMAND-SIDE ADVANTAGES: PayPal undertakes high marketing efforts to build a well-known and trusted brand, which is designed to increase brand visibility, usage and customer preference.27
26. We admit that this might be inaccurate due to P2P transactions covered in PayPal’s transactions but not in the eCommerce volume. However, determining market share in this case is difficult to do because for mayor players like WeChat Pay and Alipay the numbers are hardly obtainable due to consolidated disclosure. Moreover, one cannot calculate the market share on the number of users because users might have several accounts and the trans- action volume cannot be traced back to the number of customer accounts. This also applies for using the number of transactions as proxy. 27. Cf. PayPal (2018), annual report 2017, page 2.
8 3 Industry And Company Analysis
Measured by the number of users, the company is 2017 the world’s third largest digital payment platform with a large distance to the fourth place.28 In addition, after credit cards, digital payment methods are the second most commonly used payment method.29 This speaks for a broad accep- tance and high reputation of the brand. Furthermore, the payment process through PayPal is often a habit due to the convenience advantages and therefore almost mindless as soon as an account has been created. In combination with the annually increasing number of users and a growing market share, we assume that PayPal has a share of consumer mind and therefore a demand-side competi- tive advantage.
NETWORK ADVANTAGE: PayPal can be best described as a same side two sided network (see Graph 2 below). The main goal is to support and charge the transactions between merchants and their consumers but PayPal also integrated P2P payments. Given this, PayPal gets more worthy for its customers the more people join the network. With this regard, PayPal has already an advantage regarding the size of its network. As mentioned PayPal has the largest user base aside from their China based competitors. Such a network advantage is hard to replicate and can be even increased due to organic growth within the network. For PayPal this organic network growth is significantly driven by the C2C offer.30 Conclusively, the protected and hard to replicate network results again in a sustainable competitive advantage.
GOVERNMENT GRANTED ADVANTAGE: PayPal has regulatory licenses, which is why they are allowed to operate in different worldwide markets.31 For example PayPal owns a banking license for Europe.32 As stated above, this protects the company against competitors and new entrants.33
28. The world’s largest suppliers are WeChat Pay and Alipay, which operate mainly in China; cf. https://www.st atista.com/statistics/744944/mobile-payment-platforms-users/ (02.12.18). 29. Cf. https://www.statista.com/statistics/508988/preferred-payment-methods-of-online-shop pers-worldwide/ (02.12.18). 30. Cf. PayPal (2018), annual report 2017, page 4. 31. Cf. ibidem, page 3. 32. Cf. https://investor.visa.com/news/news-details/2017/Visa-and-PayPal-Extend-Partnershi p-to-Europe-7182017/default.aspx (04.12.18). 33. We are cautious with titling this a competitive advantage because government granted advantages can be gone in the blink of an eye and also over time more competitors can receive required licenses and therefore making the advantage non-sustainable (e.g. see regulatory consequences of Brexit).
9 3 Industry And Company Analysis
Graph 2: Illustrates the same side two sided network of PayPal. Own graphic.
CONCLUSION: Despite the poor ROIC, the high market share and annually growth as well as the assessed share of consumer mind and network advantages, PayPal embodies characteristics of a great company. Nevertheless, future development is uncertain and the market share could stagnate or decline if other mayor competitors get larger.34 As a consequence of this, we think the company quality of PayPal is only good.
34. For instance, Apple declared the future establishment of Apple Pay beyond America; cf. https://www.heise.de /mac-and-i/meldung/Apple-Pay-Europa-Ausbau-rasant-in-Arbeit-3220956.html (03.12.2018). So far we think more people are using iPhones than PayPal and therefore rather will use Apple Pay than PayPal.
10 4 V A P
4.1 Q 3: I V A M O S E
S : U
Since the valuation of a company embodies many uncertainties and assumptions about the future, we use several valuation methods to get a broader bandwidth of possible target values. The liqui- dation value (LV) of the company represents the ground floor of the intrinsic value, as it reflects the fair value of the assets minus the fair value of liability in case of (forced) liquidation.35 The replication value (RV) indicates the cost of an exact replica of the existing company using cur- rent market prices of company assets. The aim of this method is to obtain the value that would be required to rebuild the company from scratch in its current configuration. Both these values only consider the current balance sheet and ignore historical and future aspects. Furthermore, we built target values with the help of the multiplier method. This method examines key figures of a peer group and projects them to the target company. The assumption behind this is, that the peer group companies are similar to PayPal and therefore the key figures should align. Not only this assumption is very critical, but the results suffer from heavy volatility (variance) as can be seen in the appendix. Again, as with LV and RV future and historic aspects are ignored. In contrast to that, DCF and EPV use historical data to derive an estimate for future performance and base the valuation on these assumptions. Since the buyer will receive future cash flows, these methods more accurately represent his or her willingness to pay. Consequently this should be the upper limit of the valuation. In particular the DCF calculations contain high uncertainty, which is why we include a sensitivity analysis of the most critical assumption, in this case the future growth of revenues.
35. Cf. Institut der Wirtschaftsprüfer in Deutschland e.V., standard 1.18ff.
11 4 Valuation And Price
Our calculations result in the following:
• Liquidation Value: Target price of USD 12.59 per share.
• Replacement Value: Target price of USD 7.38 per share.
• Multiplier Methods: Target price in the range of USD 37.80 - 87.49 per share.36
• Earnings Power Value: Target price of USD 22.54 per share.
• Discounted Cash Flow: Target price of USD 100.14 per share.
As of December 04, 2017, three of those values result in a lower target price that the current stock market assess’ (USD 87.98). However, we consider the LV and RV as inconclusive because PayPal due to its business model is non-asset-heavy. We can also not rely on the multiplier method because of the mentioned high volatility. In addition, we assess the EPV due to its simplified approach as inaccurate. Using DCF, PayPal is currently approximately undervalued by 12%.37 The sensitivity analysis can be seen in the graph below. For detailed calculations and assumptions see the appendix.
4.2 Q 4: W ?
WHY IS IT CHEAP: The sensitivity analysis shows, that ceteris paribus a slight decrease of 0.98% in the assumed growth will lead to a DCF target value exactly at the current stock price. Thus, while we consider PayPal being undervalued other market participants with different assumptions will think otherwise. Additionally, the average investor and especially small investors are risk averse and might not capture PayPal’s future growth potential to its fullest. In conclusion, the company isn’t necessarily cheap. Thus, the margin of safety also depends on the investor’s assumptions.
WHO IS SELLING: PayPal is currently in a growing and profitable situation and not suffering from a debt overhang or otherwise huge liabilities. We conclude that if PayPal sells partly or as a
36. For this method we used two multipliers, one based on the EBIT and one on the revenue. Using the mean of the peer group we receive USD 37.80 (EBIT) and USD 87.49 (revenues) as target prices and for the median USD 38.64 (EBIT) and 58.02 (revenues). 37. 1 minus current market price divided by intrinsic DCF result.
12 4 Valuation And Price whole this transaction would be neither forced, emotional nor mindless.38 Any conducted deal that involves PayPal therefore has to grant them a competitive benefit or otherwise the price has to be adjusted at a premium over the current market price.
38. These are criteria the legendary investor Seth Klarmann assess to be very good to achieve a considerably low price and consequently a high margin of safety; cf. Jeffrey Towson (2018), Legends in Investing class 2018, lecture 5, slide 113.
13 5 D A V A
5.1 Q 5: F V A E S : A
PayPal operates in one business segment,39 which limits spin-off and break up possibilities at the point of sale. We also assess the spin-off of different country’s businesses as not purposeful because PayPal operates and brands as a global company. Liquidation of the company or other assets is not worthwhile as our calculations of LV and RV show. However, as of December 2017, PayPal has a strong balance sheet with plenty of liquidity and no long-term debt.40 So far PayPal hasn’t distributed any dividends and doesn’t anticipate paying any in the foreseeable future41 due to its focus on reinvesting their retained earnings. As a tool of financial engineering, dividend recaps or stock repurchases could increase the shareholder value. In addition, because of PayPal not having long-term liabilities, an activist investor could push PayPal’s management to issue debt. This could not only decrease the WACC due to the currently low interest rates and tax shield advantages, but also could be used for higher marketing expenditures, capital investment, acquisition or the previously mentioned shareholder value increasing possibilities.
5.2 Q 6: O V A E S : A
5.2.1 S -T
ONE TIME CASH OPTIONS: As described in the financial value add section, we believe that the approach of cash options are limited in the case of PayPal (no debt, no inventories and not a high necessity for cash).
EBITDA EXPANSION: Firstly, cost cutting is a possibility to expeditiously increase the EBITDA. We identify an over-proportional growth of transaction expense in relation to the revenues.42 Ad- ditionally, PayPal offers its employees a variety of costly benefits like comprehensive medical and
39. Cf. PayPal (2018), annual report 2017, page 7. 40. Cf. ibidem, page 57. 41. Cf. ibidem, page 28. 42. In 2017, transaction expense increased by 32% and revenues increased 21%; cf. ibidem, page 36.
14 5 Deal And Value Add dental insurances, additional holidays and free time as well as generous stock and savings compen- sation plans.43 Furthermore, after analyzing the executive compensation we noticed that PayPal pays one of the highest remunerations of the peer group.44 These three points indicate the suspi- cion, that there is a potential slack to increase cost efficiency. This potential is also reflected in PayPal having the lowest peer group gross margin.45 With regard to the above proposed merger deal, we see the opportunity for PayPal to learn from Visa’s best practice (97% gross margin) and gradually converge its operative margin.46
5.2.2 L -T
REVENUE GROWTH: Since the network improves as we explained in the beginning of this paper, we expect the companies to be able to demand higher fees after the merger has been completed. This is because the overall service offer is improving, as well as market power through economies of scale and reduced competition. With the merger PayPal and Visa are ending a long-standing conflict. In the past it was unfa- vorable for Visa that PayPal linked the online service directly to the bank account of the customer instead of their credit card. Consequently, Visa missed out on potential revenues. As a result of the merger, we assume that this process will be optimized and drive long-term revenues.
NEW POSSIBILITIES: With the merger both companies expand their current markets. PayPal is pushing in the retail market, while Visa is able to penetrate the mobile payment transaction market (smartphones). PayPal’s customers would furthermore benefit from the global Visa ATM system. Consequently, PayPal would capture new developing regions for instance Zimbabwe, where cur- rently no PayPal payments are possible.47
43. Cf. https://www.paypalbenefits.com/ (04.12.18). 44. Cf. respective annual reports. 45. These are: PayPal (46%), Visa (97%), American Express (70%), Global Payments (51%), Worldpay (53%) and Discover Financial Services (96%); cf. respective annual reports 2017. 46. Although, the core competency of Visa and PayPal may be slightly different, we believe that PayPal can realize significantly higher gross margins by cost cutting. 47. Cf. https://www.paypal.com/us/webapps/mpp/bigcommerce/security/prohibited-countries (05.12.18).
15 5 Deal And Value Add
The world’s larges provider of digital payment methods have their main market in China (WeChat Pay, Alipay), which is why PayPal has not been able to establish their brand power there. We think its almost impossible to successfully and sustainedly compete against them in the Chinese smart- phone based payment sector. With the help of Visa, they can create a PayPal credit card as a new product, which combines the advantages of both technologies. The main advantage of a credit card over a bank account based payment method is that the money is prepaid by the provider. This means, PayPal could be able to gain a foothold in the China market, hence increase long-run revenues. This is another value add created by the proposed merger. The enlarged network offers new capabilities to combine the current skill set and brainpower of the companies and develop new data driven revenue approaches. This includes the fact that PayPal will give the banks issuing Visa card more data on transactions and vice versa.
5.3 Q 7: A A E S : Y
In our opinion, the main acquisition advantage is that the merger is a mutually desirable and ad- vantageous operation, providing economies of scope that other potential bidders cannot perform. The deal requires a high capital investment and therefore smaller companies and in particular those with a lower credit rating than Visa’s (A+)48 are eliminated in the bidding process. Due to a cooperation in the past, we suspect that Visa might have an information advantage compared to other companies without a former cooperation with PayPal. Apart from these advan- tages we don’t assess significant other advantages like better management, higher political access or enhanced foreign capabilities.49
48. Cf. https://investor.visa.com/financial-information/Fixed-Income/default.aspx (05.12.18). 49. With the term foreign capabilities we don’t refer to capabilities like entering new countries, these we subsume under operational advantages.
16 6 R A R
6.1 Q 8: W C S
We identified four mayor risks conducting the proposed merger on which we elaborate below.
MULTI-SIDED PLATFORM COMPETITION: As mentioned in the industry section, competition is intense and assumed to be even higher in the future. One mayor disadvantage, both from PayPal and from Visa, is that they operate only a two-sided business model. This leaves a huge threat to other multiple sided platforms that easily could enter the payment market. A multi-sided platform can generally offer a broader variety of services and effectively link their services to each other. To out-drive competitors multi-sided platforms can even run single business segments at a disadvan- tage because of their enhanced capacity to suffer. That said, for example Facebook could decide to enter the payment industry with a similar product as WeChat Pay but for WhatsApp. PayPal already tries to minimize this multi-side platform risk by cooperating rather than competing with those platforms. For example as for now, a payment via PayPal on the Facebook messenger is already possible.50
MISMATCH GROWTH TARGETS: As shown in our valuation analysis the intrinsic value of PayPal depends highly on its future growth. In that sense, for both merging companies the future growth embodies a significant risk. E.g. large parts of the revenues are still attributable to transactions via the former parent company eBay. Ebay will end the exclusive cooperation in 2020, which is why there is a risk that revenues will decrease or stagnate.51 However, this share of revenues has already declined in recent years and was around 20% in 2017 (2015: 29%).52 In addition, we believe that the rapid development and expansion of the remaining new merger opportunities can compensate
50. Cf. https://www.cnbc.com/2017/10/20/facebook-messenger-send-money-with-paypal.html (05.12.18). 51. PayPal stock price dropped by 10% at the day of this eBay announcement; cf. https://www.handelsblatt .com/finanzen/banken-versicherungen/aktie-bricht-ein-ebay-draengt-paypal-raus-nach-15- jahren/20914552.html?ticket=ST-3275372-C42KBSI0oB6Myr4SLduj-ap4 (05.12.18) as well as the stock price on the NYSE on February 01, 2018. 52. Cf. respective annual reports 2015, 2017.
17 6 Risk And Returns for the dwindling eBay earnings. This is only one example for a reason in future revenue decline. The following list of risk factors could also adversely effect PayPal’s future revenues and growth:
• Higher payment defaults and lower overall consumer spending in the event of economic slowdown or recession.
• Security risks from cyber attacks leading to a lower trustful brand.
• Fee per transaction could inevitably decrease due to probably high proportion of large com- mercial customers.
REGULATORY RISK: Next to the government regulations impacting key aspects of PayPal’s busi- ness already,53 there might be even higher regulatory risk associated with the post-merger company size. As a result, Federal Cartel Offices could raise concerns about the monopoly position of the emerging conglomerate and even could cancel the merger if they assess that it doesn’t meet legal requirements.54
INTEGRATION FAILURES: A merger of two companies with that size can always lead to integra- tion issues. The greatest merger risk lies in the form of post-merger cooperation, i.e. organizational integration conflicts. As shown in a broad study, ”[s]uch conflict can arise for several reasons, in- cluding firm-specific human capital, corporate culture, power, or favoritism.”55 Furthermore, the companies are operating in technology based industries, meaning the amalgamation of the idiosyn- cratic company systems could lead to additional costs up to complete integration failure.
53. Cf. PayPal (2018), annual report 2017, page 5. 54. The associated uncertainty is illustrated by the recent Bayer-Monsanto merger, in which the Bundeskartellamt (Federal Cartel Office of Germany) only approved the deal under strict and repeatedly changing conditions; cf. http://europa.eu/rapid/press-release_IP-18-2322_en.htm (05.12.18). 55. Smeets et al. (2006), Mergers of Equals and Unequals.
18 6 Risk And Returns
6.2 Q 9: I M A P C T E
S : P
In the end, every investment has a residual risk. We take that into account and try to minimize this risk by running the checklist against common investor mistakes.56 Afterwards, we reassess our investment decision by using Warren Buffett’s famous punch card test, i.e. we check if this is one of the top 20 lifetime deals.
INVESTOR MISTAKES: Firstly, we check for common investor mistakes, in order to avoid them:
• Pause #1 - Confidence: PayPal operates only one business segment, which makes the com- pany less complicated to analyze in comparison to a more diversified one. As we use PayPal ourselves and since it is included in our daily life, we think we could understand and com- prehend its business. We see and understand the trend line of the business but the future outcome can only be quantified in a certain corridor of possible outcomes, which is why the future value is hard to assess as described in the valuation section above.57
• Pause #2 - What Could Hurt The Business: See question 8.
• Pause #3 - Buffett’s Questions: Buffett asks himself questions about the company’s legacy with respect to their future operations, i.e. where the company will be in 5 to 10 years. PayPal in his current independent legal structure only exists since 2015, when it was incorporated. Consequently, its operating history cannot be evaluated because it is to short to draw con- clusions. Nevertheless, in the short time period PayPal was consistently and almost linearly growing. Also, as already mentioned the future of the industry and its markets share com- position is unforeseeable. As a matter of that, this question might point towards an investor mistake.
• Pause #4 - Dead Companies Walking: PayPal with its young history, rising revenues and zero debt does not represent any characteristics of a dead company walking. We don’t think
56. Cf. Jeffrey Towson (2018), Private Equity Investment Committee class 2018, lecture 7, slide 7ff. 57. We assess the future of PayPal like a doctor and base our diagnosis on an exclusion procedure.
19 6 Risk And Returns
the management is over-optimistic or will misread their customers or shifts in the industry as we assess the management to be skilled and experienced.58 In contrary, we believe the executive team to be innovative and dynamic.59
• Pause #5 - Final Checks: After reviewing all of the done analysis and given information, our main concerns focus on the valuation and specific risk factors that interfere with our growth assumptions. On one hand, we see the opportunity for a post-merger sustained compounding but on the other hand, the probabilities might turn out to be unfavorable. Like explained above, ceteris paribus a one percent lower revenue growth rate would lead to a target value lower than the current stock price. We might do the common investor mistake of being too optimistic.
PUNCH CARD TEST: The purpose of the proposed merger is increasing the competitive advan- tages to create a lasting, protected and wealth creating company. This can be done by combining the individual strengths of the companies. Both companies have already strong and developed brands that lead to a degree of customer captivity as well as enhanced customer networks that can complement each other and achieve long-term dynamic growth. In our opinion, the result of the punch card test differs in dependency of who invests. In the view point of a passive acting investor like Warren Buffett, we don’t think that PayPal would pass the punch card test. Investment strategies like his aim for no-risk, great companies and holding them forever, while adding limited or no value. This often means no tech companies that are highly predictive.60 Today, the industry and the company are attractive as an investment but the future (5-10 years) is too uncertain. Also, PayPal’s legacy is short and thus, passively investing at this point is a common investor mistake (see Pause #3). However, we would like to emphasize that the result of the punch card test should depend solely on the positions of the two merging companies. Like explained, we propose a merger by
58. Cf. PayPal (2018), 2018 proxy statement, page 8. 59. For instance, their executive Vice President and COO Bill Ready is comparably young with his age of 38 and already has done 5 start-ups himself; cf. https://finance.yahoo.com/video/paypal-ceo-engaging-pr oductively-uk-075300862.html (05.12.18). 60. Cf. Jeffrey Towson (2018), Legends in Investing class 2018, lecture 2, slide 30.
20 6 Risk And Returns acquisition. Visa therefore doesn’t act like a passive investor but brings an operational value add to the table. In conclusion, the proposed merger passes the punch card test.
21 7 C
PayPal has revolutionized and digitalized payment transactions. While benefiting from first mover advantages in the early years, the competition is rising and PayPal’s worth dramatically depends on them keeping up their current growth. To secure the current market position and generating new possibilities we propose a merger with Visa. After deliberating the arguments, a passive investor should not invest in PayPal due to its high future uncertainties. As far as our basic idea of the merger is concerned, we also admit that we might are overenthusiastic and thus our calculations are too. Nevertheless, PayPal and Visa should conduct our proposed merger because emerging competitive advantages and operational value add offset the future uncertainties. New products are possible, new markets will be captured. The resulting conglomerate is less dependent on the future, but can shape it.
22 8 A C A : A E C
We chose American Express Company (hereafter ”AMEX”) as our additional company to analyze because it is in PayPal’s financial peer group and is an even more direct competitor of Visa, which we proposed for the merger. We do this investigation for comparison purposes using the same 9 questions. Since AMEX operates within the same industry as PayPal, we exclude question 1 (business attractiveness and predictability) from our comparison. Furthermore, we omit question 3 (intrinsic value and margin of safety) as well as question 7 (acquisition advantage).
QUESTION 2: While generating a similarly low ROIC as PayPal it can be seen that the revenues are falling in the past few years. At the same time the cost of sales increased.61 Among other factors, the overall decline in the credit card business as payment option is the reason for that.62 We think this factor is linked to the share of consumer mind. For PayPal we assessed one, partly due to its global brand power (see Question 2 above). For AMEX on the other hand, it can be seen that its outside of the U.S. revenues only make up for 34.7% of total revenues (45.9% for PayPal).63 This demonstrates a lack of globality, which in our opinion results in a lower competitive advantage with regard to customer captivity, since we think of the industry as a global industry. Another point where we assess PayPal to have an edge on AMEX, is the decreasing market share of AMEX, which can be seen in the declining revenues.64 This decline in combination with the decreasing total number of AMEX credit cards65 shows, that customers of AMEX perceive its network as less beneficial than other networks. A decreasing network is furthermore less beneficial for the remaining customers, leading to a vicious cycle. In conclusion, we assume a lower compet- itive advantage (network and share of consumer mind) compared to PayPal.
QUESTION 4: In the past monthAMEX was traded at all time high values.66 As we did not conduct a more in depth valuation we can only qualitatively address this circumstance. 61. Cf. respective annual reports. 62. Cf. https://www.statista.com/outlook/243/100/ecommerce/worldwide#market-paymentTypes (06.12.18). 63. Cf. AMEX (2018), annual report 2017, page 44 and PayPal (2018), annual report 2017, page 89. 64. Cf. respective annual reports. 65. Cf. AMEX (2018), annual report 2017, page 44. 66. Cf. https://de.finance.yahoo.com/quote/AXP?p=AXP (06.12.18).
23 8 Additional Company Analysis: American Express Company
We believe AMEX is currently overvalued and recommend investors to sell their shares. Rea- sons for that are the declining revenues in a declining market segment (credit cards), slowly rising debt level and outpacing competition. For example in 2014 Visa and AMEX, that operate in the same business, showed a very similar initial position with USD 9 billion in earnings. However, 4 years later AMEX earnings sunk as far as USD 7.5 billion, while Visa’s raised up to USD 13.5 billion. This drawback is, among other things, due to the discontinuation of AMEX’s cooperation with the U.S. retail chain Costco, which Visa took over.67 Conclusively, AMEX shows many char- acteristics of a dead company walking leading us to think that it is overvalued.
QUESTION 5 & 6: AMEX’ balance sheet almost exclusively consist of two items: Cash (18%) and receivables (72%).68 Visa’s net receivables account only for approximately 4% of total assets.69 To compensate for the decline in revenues, AMEX has to invest heavily in marketing and promote their strong value brand name, which they did in the last years.70 Trough a better receivables manage- ment we think that AMEX will obtain the necessary financial resources more quickly. Furthermore, AMEX could use their surplus in cash not only for advertising but also for lowering their long-term debts and thus decreasing interest expenses. AMEX could also look for a deal similar to the deal proposed in this paper. This would give them the opportunity to improve the declining credit card business with the benefits of the increasing mobile payment solutions.
QUESTION 8: For AMEX one of the bad outcomes is, that the identified trends associated with the business model keep continuing as for now (decline in credit card payments, increased compe- tition). Besides the mentioned multi-sided platform competition, growth and regulatory risks (see question 8 above), we also think that AMEX is exposed to higher risks regarding losing more coop- eration partners to competitors like Visa. To match the current competition, we assume that AMEX will tend to more aggressive lending than previously, which increases overall risk, especially credit
67. Cf. https://www.marketwatch.com/story/5-things-to-know-about-the-costco-and-amex-breaku p-2016-02-11 (06.12.28). 68. Cf. AMEX (2018), annual report 2017, page 37. 69. Cf. Visa (2018), annual report 2017, page 58. 70. Cf. respective annual reports.
24 8 Additional Company Analysis: American Express Company defaults and enhance exposure to adverse market conditions. As a result, we deliberate that the worst case scenario of AMEX is worse than that of PayPal.
QUESTION 9: We operationalize our investment strategy in the form of checklists. So far, AMEX did not pass the checklist to be considered as an investment. Of course, the individual answers to the questions are associated with uncertainties and points worth discussing, but we believe that an investment in AMEX is not a good investment and at best a decision that is too hard to determine. AMEX does not pass the punch card test.
25 9 A
26 9 Appendix
27 9 Appendix
WACC Calculations Number in million Name (unless percentage) Description Source firm value, shares outstanding multiplied Market capitalization 105.590 with latest share price coversheet, annual report 2017 residual market value of equity after Equity 84.005 substracting total debt from the firm value - average book value of total liabilities 2017, Total Liabilities 21.586 2016 page 57, annual report 2017 risk free rate of return, 10 years government https://www.bloomberg.com/markets/rates- rf 0,46% bonds of Germany as proxy bonds/government-bonds/germany correlation between PayPal's stock price https://de.finance.yahoo.com/quote/2PP.DE Beta 1,24 return to market return ?p=2PP.DE&.tsrc=fin-srch-v1 https://assets.kpmg.com/content/dam/kpmg/ ch/pdf/cost-of-capital-study-2016-de.pdf, Risk Premium 6,10% demanded average market premium page 27
reflects the expected rate of return of equity rE 8,02% sponsors, rE = rf + beta*(risk premium) - Average Interest "interest for the years 2017,2016,2015 was Expenses 0 not material" page 36, annual report 2017 Average Effective Tax Rate 16,00% average effective tax rate 2017,2016 page 40, annual report 2017 average cost of debt, average interest expense paid divided by average total debt rD 0,00% 2017,2016 - WACC=E/V*cost of equity + D/V*cost WACC 8,02% of debt*(1-t) -
28 9 Appendix
Earnings Power Value (EPV) Calculations Number in million Name (unless percentage) Description Source EBIT 1.914,0 earnings before interest and taxes 2017 page 58, annual report 2017 average effective tax rate 16,0% see WACC calculations page 40, annual report 2017 EBIT adjusted for the average effective tax EBT 1.607,8 rate - D&A 513,0 depreciation and armortization page 58, annual report 2017
CAPEX maintainence 76,4 assume 5% of fixed asset (PPE) value page 57, annual report 2017 Adjusted EBT 2.044,4 EBT + D&A - CAPEX maintainence - WACC 8,02% see WACC calculations - EPV 25.478,1 - assuming the company needs 10% of its Exess cash 1.573,6 revenues in cash as working capital page 57f., annual report 2017 LT debt and borrowings 0,0 long-term debt and short-term borrowings page 57, annual report 2017 EPV + exess cash - LT debt and Equity value 27.051,7 borrowings - Shares 1.200,16 number of shares outstanding see key statistics predicted equity value per share Target price 22,54 outstanding -
29 9 Appendix
PayPal - Balance Sheet 2017 (in million)
Item Book Adjustment Replacement Description Current Assets Cash And Cash Equivalents 2.883,0 2.883,0 No information in the annual report, 5% allowance for doubtful Net Receivables 1.597,0 -79,9 1.517,2 accounts assumed.
Inventory 0,0 0,0 0,0
Other Current Assets 28.165,0 -1.408,3 26.756,8 Blanket adjustment for present value (-5%). Total Current Assets 32.645,0 -1.488,1 31.156,9 Long Term Investments 1.961,0 1.961,0 Blanket adjustment of 10%, since property and plant worth is Property Plant and Equipment 1.528,0 152,8 1.680,8 generally rising but accounting wise cant be added. Goodwill 4.339,0 -4.339,0 0,0 Accounting goodwill would not be replaced. Customer list and user base, marketing, technologies and Intangible Assets 168,0 33,6 201,6 others, cf. annual report 2017, page 76. We assume replication to require a 20% premium on the net carrying amount.
Other Assets 133,0 -6,7 126,4 Blanket adjustment for present value (-5%). Total Assets 40.774,0 -7.135,5 33.638,6 Current Liabilities Accounts Payable 257,0 257,0 Short Term Borrowings 0,0 0,0 Other Current Liabilities 22.606,0 22.606,0 Total Current Liabilities 22.863,0 22.863,0 Long Term Debt 0,0 0,0 Other Liabilities 1.917,0 1.917,0 Minority Interest 0,0 0,0 Total Liabilities 24.780,0 24.780,0 Stockholders' Equity Retained Earnings 3.823,0 -7.135,5 -3.312,5 Additional Paid-In-Capital 14.314,0 14.314,0 Treasury Stock -2.001,0 -2.001,0 Net Parent Investment 0,0 0,0 Other Stockholder Equity -142,0 -142,0 Total Stockholder Equity 15.994,0 15.994,0 Net Tangible Assets 15.994,0 -7.135,5 8.858,6 Shares outstanding 1.200,2 Replacement value 7,38
30 9 Appendix
PayPal - Balance Sheet 2017 (in million)
Item Book Adjustment Liquidation Description Current Assets Cash And Cash Equivalents 2.883,0 2.883,0 No information in the annual report, 5% allowance for doubtful Net Receivables 1.597,0 -79,9 1.517,2 accounts assumed.
Inventory 0,0 0,0 0,0
Blanket adjustment for present value (-10%). Since we dont know the total amount of total expenses becaue it's a Other Current Assets 28.165,0 -2.816,5 25.348,5 consolidated balance sheet item (cf. Annual report 2017, page 57), we increase the blanket adjustment.
Total Current Assets 32.645,0 -2.896,4 29.748,7 Long Term Investments 1.961,0 1.961,0 Blanket adjustment of 5%, since property and plant worth is Property Plant and Equipment 1.528,0 76,4 1.604,4 generally rising but accounting wise cant be added. More conservative than in the replacement value calculation. Goodwill 4.339,0 -4.339,0 0,0 Accounting goodwill would not be replaced.
Customer list and user base, marketing, technologies and others, cf. annual report 2017, page 76. We assume replication Intangible Assets 168,0 33,6 201,6 to require a 15% premium on the net carrying amount. More conservative than in the replacement value calculation.
Blanket adjustment for present value (-10%). Since we dont know the total amount of total expenses becaue it's a Other Assets 133,0 -13,3 119,7 consolidated balance sheet item (cf. Annual report 2017, page 57), we increase the blanket adjustment. Total Assets 40.774,0 -10.035,0 30.739,0 Current Liabilities Accounts Payable 257,0 -102,8 154,2 Renegotiate with creditors (-40%). Short Term Borrowings 0,0 0,0 Other Current Liabilities 22.606,0 -9.042,4 13.563,6 Renegotiate with customers (-40%). Total Current Liabilities 22.863,0 -9.145,2 13.717,8 Long Term Debt 0,0 0,0
Other liabilities include accrued expenses and hedging Other Liabilities 1.917,0 1.917,0 instruments (cf. annual report 2017, pages 67, 82 and 87). We therefore assume no renegotiation for this item is possible.
Minority Interest 0,0 0,0 Total Liabilities 24.780,0 -9.145,2 15.634,8 Stockholders' Equity Retained Earnings 3.823,0 -889,8 2.933,2 Additional Paid-In-Capital 14.314,0 14.314,0 Treasury Stock -2.001,0 -2.001,0 Net Parent Investment 0,0 0,0 Other Stockholder Equity -142,0 -142,0 Total Stockholder Equity 15.994,0 15.994,0 Net Tangible Assets 15.994,0 -889,8 15.104,2 Shares outstanding 1.200,2 Liquidation value 12,59
31 9 Appendix
PayPal - Multiplicator Method Financial Company Market Capitalization/EBIT Market Capitalization/Revenues Visa 22,6 14,8 MasterCard 30,4 16,6 American Express 12,2 3,0 Global Payments 25,9 4,3 Worldpay 45,0 6,4 Discover Financial Services 6,2 3,0 Mean 23,7 8,0 Median 24,2 5,3 Variance 189,5 37,3 Target Value PayPal (mean) 45.368,2 105.005,5 Target Stock Price 37,80 87,49 Target Value PayPal (median) 46.380,0 69.635,3 Target Stock Price 38,64 58,02
32 9 Appendix
PayPal - Balance Sheet (in million) Year 2014 2015 2016 2017 Current Assets Cash And Cash Equivalents 2.201,0 1.393,0 1.590,0 2.883,0 Net Receivables 4.345,0 4.321,0 5.562,0 1.597,0 Inventory 0,0 0,0 0,0 0,0 Other Current Assets 11.019,0 14.934,0 18.581,0 28.165,0 Total Current Assets 17.565,0 20.648,0 25.733,0 32.645,0 Long Term Investments 31,0 2.348,0 1.539,0 1.961,0 Property Plant and Equipment 922,0 1.344,0 1.482,0 1.528,0 Goodwill 3.189,0 4.069,0 4.059,0 4.339,0 Intangible Assets 156,0 358,0 211,0 168,0 Other Assets 54,0 114,0 79,0 133,0 Deferred Long Term Asset 10,0 38,0 21,0 95,0 Charges Total Assets 21.917,0 28.881,0 33.103,0 40.774,0 Current Liabilities Accounts Payable 115,0 145,0 192,0 257,0 Short Term Borrowings 0,0 0,0 0,0 0,0 Other Current Liabilities 13.168,0 13.472,0 16.686,0 22.606,0 Total Current Liabilities 13.283,0 13.617,0 16.878,0 22.863,0 Long Term Debt 0,0 0,0 0,0 0,0 Other Liabilities 386,0 1.505,0 1.513,0 1.917,0 Minority Interest 0,0 0,0 0,0 0,0 Total Liabilities 13.669,0 15.122,0 18.391,0 24.780,0 Stockholders' Equity Retained Earnings 0,0 668,0 2.069,0 3.823,0 Additional Paid-In-Capital 0,0 13.100,0 13.579,0 14.314,0 Treasury Stock 0,0 0,0 -995,0 -2.001,0 Net Parent Investment 8.138,0 0,0 0,0 0,0 Other Stockholder Equity 110,0 -9,0 59,0 -142,0 Total Stockholder Equity 8.248,0 13.759,0 14.712,0 15.994,0 Net Tangible Assets 8.248,0 13.759,0 14.712,0 15.994,0
33 9 Appendix
34 9 Appendix
PayPal - Cash Flow Statement (in million) Year 2014 2015 2016 2017 Net Income Net Income 419,0 1.228,0 1.401,0 1.795,0 Operating Activities, Cash Flows Provided By or Used In Depreciation 387,0 442,0 516,0 513,0 Adjustments To Net Income 1.584,0 1.216,0 1.513,0 542,0 Changes In Accounts Receivables -13,0 -22,0 -77,0 12,0 Changes In Liabilities 42,0 12,0 11,0 62,0 Changes In Inventories 0,0 0,0 0,0 0,0 Changes In Other Operating Activities -365,0 -536,0 -484,0 -674,0 Others 166,0 206,0 278,0 281,0 Total Cash Flow From Operating 2.220,0 2.546,0 3.158,0 2.531,0 Activities Investing Activities, Cash Flows Provided By or Used In Capital Expenditures -492,0 -722,0 -669,0 -667,0 Investment in Assets -978,0 -5.478,0 -2.612,0 -968,0 Other Cash flows from Investing -1.411,0 -1.838,0 -1.718,0 -3.723,0 Activities Total Cash Flows From Investing -2.881,0 -8.038,0 -4.999,0 -5.358,0 Activities Financing Activities, Cash Flows Provided By or Used In Dividends Paid 0,0 0,0 0,0 0,0 Net Borrowings -21,0 -862,0 -21,0 820,0 Proceeds from issuance of common 0,0 75,0 109,0 144,0 stock Purchases of treasury stock 0,0 0,0 -995,0 -1.006,0 Excess tax benefits from stock-based 41,0 26,0 40,0 0,0 compensation Contribution from (to) eBay -71,0 3.858,0 0,0 0,0 Tax withholdings related to net share settlements of restricted stock units and 0,0 -18,0 -118,0 -166,0 restricted stock awards Funds payable and amounts due to 1.335,0 1.649,0 3.023,0 4.292,0 customers Total Cash Flows From Financing 1.284,0 4.728,0 2.038,0 4.084,0 Activities Effect Of Exchange Rate Changes -26,0 -44,0 0,0 36,0 Change In Cash and Cash 597,0 -808,0 197,0 1.293,0 Equivalents
35